How Do Landlords Make Money?

Landlords weigh the price of the property against the rent they can collect.

In the commerce of real estate, one person’s investment is another person’s home. While you may be drawn to the hardwood floors and panoramic views, your landlord is more likely thinking about rent yields and cap rates. If that sounds like a foreign language, it’s time you learn to speak property investor.

Double Bonus

Landlords make money from rentals in two primary ways. First, they collect your rent. Assuming that your monthly rent check covers the landlord’s expenses, what’s left in the pot gives him an income. Second, your landlord banks on the rental property appreciating in long-term value. Averaging out the blips, house prices have gone up by 4.5 percent per year since 1975, according to Forbes. Landlords cash out the equity when they sell or refinance.

Other People's Money

The key to making the numbers stack up is other people’s money. Investors don’t buy rental property with cash, even if they can afford to. They let other people -- specifically the tenant -- buy the property for them. When an investor finds a property he likes, he’ll buy it with a mortgage. Typically, that mortgage will cover 75 percent to 80 percent of the property’s value. As long as your landlord collects enough rent, the tenant will cover the interest and principal repayments. After 30 years or sooner, your landlord has a building that he owns outright, having contributed only 20 percent of his own money.

Declaring a Paper Loss

The tax system weighs heavily in a landlord’s favor. Your landlord can deduct the mortgage interest, along with a number of operating expenses such as property taxes, insurance and maintenance costs from the rental income he receives. He may even depreciate the property to reduce his tax. Depreciation lets your landlord deduct a percentage of the rental unit's purchase price from his taxable income, to account for the building wearing out and losing value over time. The IRS permits such deductions even if the property is not losing value in real life. On paper, the rental may show a loss even if the landlord turns a profit. This reduces the income tax a landlord has to pay.

Playing the Market

Professional landlords are investors who evaluate the potential dollar return of a property before deciding whether to buy. One financial marker is the capitalization, or cap rate. The cap rate is the ratio between the property's net income and the value of the property. For example, if your landlord buys a property for $100,000 and collects $10,000 in annual rent after deducting his costs, his cap rate is 10 percent. Property values go up and down over time. By keeping an eye on his cap rate, your landlord is able to determine the best time to sell and invest the proceeds elsewhere.